Certified Valuation Analyst (CVA) Practice Exam

What is the only difference between the build-up method and the modified capital asset pricing model?

1. The market risk premium

2. The beta

3. The cost of equity

4. The risk-free rate

The correct answer is: The beta

The distinction between the build-up method and the modified capital asset pricing model (CAPM) primarily lies in the treatment of systematic risk, which is represented by beta in the modified CAPM. The build-up method does not utilize beta but instead relies on an additive approach that combines various risk premiums to determine the required return. In contrast, the modified CAPM incorporates beta as a measure of systematic risk, which assesses the sensitivity of an investment's returns to market returns. Thus, in the context of valuation, using beta allows analysts to directly account for the investment's risk relative to the overall market, providing a different perspective compared to the build-up method. Understanding this difference is essential for applying the correct valuation model based on the circumstances of the asset being valued and the preferences of the analyst.